Sri Lanka next in line for an exchange rate crisis: Nomura Economists

Sri Lanka is at the top of a list of seven emerging market countries that Nomura believes are most likely to join nations such as Turkey and Argentina in a currency crisis.

Nomura economists estimate the fourth quarter of this year will be the point at which global monetary conditions switch over from loose to tight for the first time since the global financial crisis.

The team took a deep dive into how the changing markets backdrop – of which monetary conditions are one facet – could work to further weigh on the prospects for the emerging markets that have attracted large amounts of investor capital over the last ten years.

Given the developments that have already taken place this year in countries such as Argentina, “the question of which countries are more vulnerable is of utmost importance,” the economists said.

Nomura’s “Damocles” model showed Sri Lanka, South Africa, Argentina, Pakistan, Egypt, Turkey and Ukraine as the next in line for an exchange rate crisis.

That is due to still-weak fiscal finances and a very fragile external position, they said.

“With foreign exchange reserves of less than five months of import cover and high short-term external debt of around $US160 billion, its refinancing needs are large. Political stability also remains an issue.”

Pockets of strength

The economists used eight indicators as they tried to predict the next emerging market currency crisis – import cover, short-term external debt/exports, exchange rate reserves/short-term external debt, broad money/exchange rate reserves and real short-term interest rate.

Non-foreign direct investment gross inflows over one and three years, fiscal and current account, and current account and real effective exchange rate deviation were taken into account.

While there were some standout areas of weakness there were some pockets of strength as well. Eight countries – Brazil, Bulgaria, Indonesia, Kazakhstan, Peru, Philippines, Russia and Thailand – scored zero on the model.

“This is an important result. As investors focus more on risk, it is important not to lump all emerging markets together as one homogeneous group,” the economists said.

Overall, “in many ways, emerging markets are sailing into uncharted waters,” they noted.

The picture is changing for capital inflows into emerging markets, the economists said, while projecting weaker inflows ahead.

Interest rates have started to rise in the US and that is attracting investors back to US assets, with the US dollar index rising more than 7 per cent from its lows hit earlier in the year.

Times have changed

Oil prices are playing a part for emerging markets as well.

Higher oil prices are good for some oil exporters such as Saudi Arabia, Russia, Nigeria, Ecuador and Colombia, the Nomura economists noted, but bad news for the majority of emerging market economies which are net oil importers.

“As such [they] face widening current account deficits (or shrinking surpluses), particularly in Asia,” the economists noted.

The economists also said that there are some new factors in play in emerging markets, compared to twenty years ago.

For example assets under management at the top 500 asset management firms in the world have now reached approximately the same size of global GDP, they said, and these firms have invested heavily in emerging markets.

That raises questions of what could happen if these firms decided to retreat en-masse from emerging market debt markets and whether algorithmic trading and passive investment strategies could lead to more herding behavior in such a move, the economists noted.

UPDATE:  Sri Lanka denies reports economy at risk of exchange rate crisis

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